Fast Forward

By

Andrew Bary

Updated Sept. 27, 2004 12:01 a.m. ET

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WALL STREET MIGHT HAVE ITS FAIR SHARE of film buffs, but it's hard to find any analysts or investors with a kind word for video-rental stocks. Indeed, the group probably ranks among the Street's least admired industries, right above the long-distance telephone business.

Blockbuster, the giant of the video-rental field, has borne the brunt of this disregard. Its shares have fallen 42% this year, to $7.37 apiece, amid concerns about eroding profits and the long-term viability of video-rental stores. Skeptics cite heightened competitive threats to the business, ranging from booming sales of cheap DVDs by retailers such as
Wal-Mart Stores
to the success of video-by-mail specialist
Netflix
and the growth in video-on-demand services from
Comcast
and other cable TV operators.

"People look at me as though I've lost my mind," says one broker, who nonetheless is recommending Blockbuster to clients.

Blockbuster's stock also has come under arbitrage-related pressure, because majority-owner
Viacom
early next month will distribute its 81% stake in the company -- some 144 million shares -- to Viacom shareholders, through a mechanism called a split-off. The action comes after Viacom opted not to sell Blockbuster earlier this year. Under the terms of the deal, Viacom holders can swap their shares for Blockbuster stock. Arbitragers have been buying Viacom and selling Blockbuster short to capture a modest spread.

When stocks are widely hated, as Blockbuster surely is, they're often worth a look. It is under such circumstances that investment opportunities tend to arise. Such was the case earlier this year with
MCI,
another much-scorned issue, whose shares shot up to 17 from 13 in recent months amid buyout rumors (see "Worth Ringing Up?," in Barron's, May 10, 2004).

Dallas-based Blockbuster could be another winner, not least because it is reasonably priced by most valuation measures. The company sports an experienced and well-regarded management team, and is engaged in multiple initiatives to reduce its reliance on the eroding video-rental business.

If Blockbuster demonstrates some success in transforming itself from a "rentailer" into a "specialty retailer of home-entertainment products," as is its stated goal, its stock easily could top $10 in the next year. Among its efforts, the company rolled out a Netflix-style video-rental service in August, a "store-within-a-store" for video-game sales and trading in many of its U.S. locations, and a DVD-trading program that allows customers to sell their used DVDs to Blockbuster for store credits. This program should be available in 2,000 of Blockbuster's nearly 6,000 U.S. stores by year end, and in all stores by the end of 2005.

An upbeat John Antioco, 54, Blockbuster's chief executive, began a roadshow last week, ahead of the Viacom spinoff, and sought to confront investors' fears directly.

"We acknowledge that transactional rentals, where people rent one or two videos at a time, will decline, but it will still remain a substantial $7 billion-to-$8 billion-a-year business," says Antioco, who has been Blockbuster's CEO for the past seven years.

The "eye opener" for some investors, he adds, is the sales and profit potential from Blockbuster's newer businesses. "We're taking Blockbuster from a place where you rent movies to a place where you can rent, buy or trade a movie or game, new or used, pay-by-the-day, pay-by-the-month, in-store or on-line." There's plenty of opportunity for Blockbuster, because it boasts 40 million active U.S. customers, defined as those who have rented a movie or game in the past year. That's 20 times Netflix's subscriber base. The company has a large presence abroad, notably in Britain.

Wall Street is taking a "show me" attitude, however, because of the costs associated with these initiatives, and many doubt they will succeed. One dubious investor calls Blockbuster a "melting ice cube."

The skepticism is reflected in Blockbuster's depressed shares, which trade for about eight times projected 2004 profits of 97 cents per share, and eight times estimated 2005 net of 90 cents a share. The company's equity market value is just $1.3 billion. The combined value of its equity and $900 million in debt is only four times projected 2004 pretax cash flow of about $550 million, with cash flow defined as earnings before interest, taxes, depreciation and amortization, a valuation measure used in the media and retailing sectors.

Blockbuster's price/earnings ratio and its cash-flow ratio are among the lowest in the retailing industry and within the S&P 500 index. The company's book value is almost $14 a share, but all of that consists of goodwill.

Blockbuster's free cash flow after capital expenditures was over $400 million in 2003, resulting in an enormous free-cash-flow yield on the stock of 30%. Free cash flow could fall to $200 million this year, but if it can approach $300 million by 2006, Blockbuster's stock is apt to be much higher by then. The dividend yield is small, however, at 1%.

Blockbuster trades at a sharp discount to rival Netflix, whose shares, at around 17, trade for 14 times estimated 2005 net. Blockbuster's P/E is so low because of fears that its earnings power is permanently impaired and that it won't come close to netting $1 a share annually ever again. The company earned $1.48 a share last year from operations.

The backdrop for Blockbuster clearly isn't great. When the company announced second-quarter earnings in July, it said second-half profit would be well below Wall Street expectations. Blockbuster blamed "challenging" conditions in the video-rental market, which it expects to persist into the first half of 2005. The current quarter is expected to be weak, partly because many Americans were watching the Olympics last month, not renting DVDs. Blockbuster expects a "mid-single-digit" percentage decline in same-store sales in the current quarter.

Blockbuster's results also are under pressure because of spending associated with its new sales initiatives. Second-half earnings could total just 30 cents a share, versus 67 cents in the first half of 2004. In 2005, Blockbuster sees continued pressure on profit. Antioco calls 2004 and 2005 "deployment" years that will yield a payoff starting in late 2005 and 2006.

Blockbuster has $6 billion in annual revenue. It sees an opportunity to increase that because total U.S. sales and rentals of movies and video games, new and used, exceeded $30 billion in 2003 and could hit $40 billion by 2006.

Given its cost structure, Blockbuster can't easily slug it out with Wal-Mart in DVD sales since Wal-Mart often sells DVDs at or near cost to drive traffic. Selling DVDs priced for $15 to $20 poses a challenge to Blockbuster, which charges about $3.50 a night for rentals.

Yet Blockbuster's trading strategy could turn the DVD-buying boom to its advantage. Americans now own an estimated two billion DVDs and are adding to their collections at a rate of one billion annually. A good chunk of these DVDs might end up in permanent "libraries," but many people have no interest in watching a movie more than once or twice. Blockbuster hopes to enable them to monetize used DVDs, which the company could then rent or sell. What would Blockbuster pay for the DVD of Lost in Translation? Antioco, sitting in a San Francisco hotel room, clicked on his computer and answered: $7. The price for other used DVDs will reflect supply and demand.

Antioco has a big financial incentive to succeed. Under a new employment contract, he'll get one million to 2.5 million shares of restricted stock and 4.2 million to five million options, all struck around current prices.

Blockbuster can be criticized for being slow to counter Netflix, but it finally has responded. It offers a video-subscription service, either in-store or by mail, that give consumers the opportunity to rent an unlimited number of movies each month. The on-line Netflix-type program allows subscribers to rent three DVDs at a time and costs $19.95 a month, a $2-a-month discount to Netflix. Antioco has high hopes for both initiatives, including the in-store offering, which he says could attract 8% of Blockbuster's active users by year end. In 2005, Blockbuster aims to combine the two services and allow customers to get or drop off movies either by mail or in stores.

The systems investment related to these projects is one reason Blockbuster's profits are under pressure, though Netflix shares also have been hurt by Blockbuster's initiative and rising subscriber-acquisition costs. Netflix fell sharply in July, and trades around 17, half its early-'04 high.

Blockbuster shares weren't helped by news last month that a buyout offer for a smaller rival,
Hollywood Entertainment,
had fizzled. A group led by Leonard Green & Partners offered to buy Hollywood for $14 a share, or $900 million, in March, but backed off in August after failing to get financing. As a result, Hollywood's stock has fallen below 10.

One of the biggest knocks against Blockbuster is the threat from video-on-demand, which cable operators are pushing. Why should people take time to go to a Blockbuster to rent movies and then return them -- risking pesky late fees -- when they can push a button on a television instead?

Antioco responds that motion-picture studios have too much invested in the DVD business to let it shrivel or die. Specifically, they generate half their revenues and most of their profits from DVDs. Blockbuster currently enjoys an advantage because movies are released on DVD 45 to 60 days before they're made available on pay-per-view cable. "It's strictly a matter of economics for the studios," Antioco says. "There has never been greater incentive for them to maintain the [DVD-release] window."

The studios might generate $15 per copy from DVD sales, versus about $3 from pay-per-view. It would take a huge increase in video-on-demand sales to offset lost DVD revenues.

There's financial risk with Blockbuster because the formerly debt-free company now has more than $900 million of debt, net of cash. Those borrowings were incurred to pay a $5-a-share dividend to shareholders, principally Viacom, earlier this month. That dividend sliced the price of Blockbuster stock to $8 from $13.

The dividend and associated debt effectively makes Blockbuster a public leveraged buyout, giving greater upside -- and downside -- to the stock.

The debt doesn't worry Antioco, who notes the leverage is less than what Blockbuster carried at its 1999 IPO. "We have enough financial flexibility to carry out our mission," he says. Debt is less than two times pretax cash flow, a manageable level.

After Viacom distributes its 144 million Blockbuster shares, Blockbuster will have two classes of stock outstanding: the current stock, which will become A shares, and newly issued B stock.

The straight-talking Antioco told shareholders in a recent letter that Blockbuster's transformation "will not be easy." But this is one story that could have a Hollywood ending.

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